CDS Implied Probability of Default Calculator
Estimate the implied annual and cumulative probability of default for a reference entity based on its Credit Default Swap (CDS) spread, expected recovery rate, and contract tenor.
What is a Credit Default Swap (CDS)?
A Credit Default Swap (CDS) is a financial derivative that acts like an insurance policy against the default of a specific debt instrument (like a bond) or a reference entity (like a company or sovereign nation). The buyer of the CDS (protection buyer) pays a periodic premium to the seller of the CDS (protection seller). In return, if the reference entity defaults, the protection seller compensates the buyer for the loss incurred.
Understanding CDS Spreads
The "CDS Spread" is the annual premium paid by the protection buyer to the protection seller, typically quoted in basis points (bps). One basis point equals 0.01%. So, a CDS spread of 100 bps means the buyer pays 1% of the notional amount annually. A higher CDS spread indicates that the market perceives a higher risk of default for the reference entity.
How This Calculator Works: Implied Probability of Default
This calculator helps you estimate the market's implied probability of default for a reference entity, given its CDS spread, an assumed recovery rate, and the tenor (duration) of the CDS contract. It uses a simplified model where the CDS spread is approximately equal to the annual hazard rate (which is close to the annual probability of default for small probabilities) multiplied by the Loss Given Default (LGD).
The Loss Given Default is simply 1 minus the Recovery Rate. For example, if the recovery rate is 40%, the LGD is 60% (or 0.6). The calculator then uses this annual hazard rate to determine the cumulative probability of default over the specified tenor.
Key Inputs Explained:
- CDS Spread (Basis Points): This is the annual premium rate for the CDS, expressed in basis points (100 bps = 1%). It reflects the market's perception of the credit risk.
- Recovery Rate (%): This is the estimated percentage of the notional amount that bondholders would recover in the event of a default. It's an important assumption, as higher recovery rates imply lower actual losses for the protection seller.
- Tenor (Years): This is the duration or maturity of the CDS contract, typically ranging from 1 to 10 years, with 5 years being a common standard.
Interpreting the Results:
- Implied Annual Hazard Rate (%): This represents the estimated annual probability that the reference entity will default. It's derived directly from the CDS spread and the assumed recovery rate.
- Cumulative Probability of Default over Tenor (%): This is the total probability that the reference entity will default at least once over the entire duration of the CDS contract (the specified tenor).
Important Considerations and Limitations:
This calculator uses a simplified model for estimating default probabilities. Real-world CDS pricing is significantly more complex, involving factors such as:
- Discounting: Future cash flows (premiums and potential default payments) are discounted to present value.
- Default Intensity Models: More sophisticated models use stochastic processes for default intensity.
- Market Liquidity: The liquidity of the CDS market can influence spreads.
- Basis Risk: Differences between the reference obligation and the deliverable obligation.
- Counterparty Risk: The risk that the CDS protection seller might default.
Therefore, the results from this calculator should be used for illustrative and educational purposes only and not as a basis for actual trading or investment decisions.